Communication from the Commission - European capital markets for small and medium-sized enterprises: prospects and potential obstacles to progress
Date: 1997-05-05
Institutions: European Commission
Subjects: capital market, financial market, investment, small and medium-sized enterprises, stock exchange

COMMISSION OF THE EUROPEAN COMMUNITIES 

Brussels,  05.05.1997 
COM(97) 187  final 

COMMUNICATION  FROM THE  COMMISSION 

European capital markets for Small and Medium-sized Enterprises: 
prospects and potential obstacles to progress 

CONTENTS 

I. 

II. 

III. 

IV. 

INTRODUCTION 

FURTHER PROGRESS IN THE DEVELOPMENT OF SME CAPITAL 
MARKETS IN THE EUROPEAN UNION, AND THEIR PROSPECTS 

POTENTIAL OBSTACLES TO THE LISTING OF SMEs ON STOCK 
EXCHANGES 

POTENTIAL BARRIERS TO THE CROSS-BORDER TRADING OF 
SHARES ON EUROPEAN SME CAPITAL MARKETS 

IV.i.  Currency-related  problems 
IV.ii.  The regulation of securities trading at the EU level 
IV.iii.  Differences  in national laws and practices 
IV.iv.  Institutional  investment 

V. 

CONCLUSIONS 

A 

I. 

INTRODUCTION 

One of the financial  problems faced  by many fast-growing  European  Small  and  Medium-
sized  Enterprises  (SMEs)  is  the  difficulty  in  raising  on  European  capital  markets  the 
external  equity  capital  they  need  for  expansion.  The  European  Commission  has  already 
taken up the issue of access for  European  SMEs to  capital  markets:  its progress  to  date 
was  summarised  in  a  Communication  of  25th  October  19951,  which  noted  that  the 
absence  of provision  of  SME capital  markets  in Europe  has led  an increasing  number  of 
European  companies  to  seek  flotation  on  US  stock  markets,  especially  the  NASDAQ 
market2,  and has also restricted the opportunities  for  European  venture capitalists  to  exit 
from  their investments.  New  SME capital  markets are to be encouraged  not  only  because 
of  the  directly  beneficial  effect  they  could  have  in  allowing  firms  to  access  long-term 
finance,  but also for the positive role they could play in stimulating the  European  venture 
capital industry, and financial  services in Europe. 

The  1995  Communication  also  summarised  the  role  played  by  the  Commission  in  the 
financing  of a feasibility  study by the European Venture Capital Association  (EVCA) into 
the possible creation of a European capital market for  growing  SMEs, and in the creation 
of the  European  Association  of  Securities  Dealers,  which  arose  out  of  that  study.  The 
positive  conclusion  of the EVCA  study  influenced,  directly  or  indirectly,  the  creation  so 
far  of two  private  sector  financed  projects  for  the  creation  of a European  capital  market 
for  growing  internationally-oriented  SMEs.  These  two  initiatives,  described  in  that 
Communication,  are  the  EASDAQ  market  (European  Association  of  Securities  Dealers 
Automated Quotation), and the Nouveau Marché/Euro-NM initiative. 

These  encouraging  and  promising  initiatives  were  made  possible  by  the  liberalisation 
brought  about by Community legislation,  in particular the Investment  Services Directive3, 
which allows securities traders to deal anywhere in the Union on the basis of a "passport" 
provided  by  the  regulator  in  their  home  Member  State,  and  opens  up  regulated  EU 
securities  markets  to  "remote  membership"  for  traders  located  in  other  Member  States. 
However,  the Communication  noted  that  while the  existing body  of  European  law,  once 
fully  in force,  should  allow the creation  of these  markets,  a number  of possible  obstacles 
had been identified  which might hamper the efficiency  of their operations. 

The Industry Council of 6th and 7th November  1995 asked the Commission  "to go deeper 
into the  conclusions  of its Communication  and  report  on ways  to  overcome  the  various 
obstacles  currently  existing  in  the  Member  States,  including  obstacles  inhibiting  the 
channelling of funds  of institutional  and private investors, in order to  support  the creation 
of  secondary  European  capital  markets  for  SMEs,  taking  into  account  the  national 
systems and experiences already under way." The European Parliament,  in a resolution  of 
4 July  19964, welcomed the Commission's Communication,  and the initiatives it described, 
but  noted  that  for  the  new  markets  to  be  successful,  a  number  of  issues,  including 
liquidity, regulation, and possible protectionism, needed to be addressed. 

1 COM (95) 498 final, entitled "reporting on the feasibility  of the creation of a European Capital  Market 

for smaller entrcpreneurially managed growing companies". 
2  See also the Commission's Green Paper on Innovation, COM(95) 688 final. 
3  93/22/EEC, of 10.5.1993. 
4 A4-0168/96 

1  « 

This further  Communication  therefore  sets  out  to  respond  to  those  requests  by  defining 
better  the  potential  obstacles  to  the  efficient  operation  of these  new  capital  markets  for 
growing  SMEs. First  of all, however,  it  describes  recent  developments  in the  creation  of 
SME capital markets in Europe, and discusses their perspectives; it then outlines the many 
barriers of attitude and capability regarding stock market flotation  which can hinder SMEs 
from  seeking a flotation; finally, it deals with more specific barriers to cross-border trading 
in  equities  in  general,  and  on  SME  capital  markets  in  particular,  for  example,  in  the 
regulatory and legal  fields. 

II. 

FURTHER PROGRESS IN THE DEVELOPMENT OF SME CAPITAL 
MARKETS IN THE EUROPEAN UNION, AND THEIR PROSPECTS 

Since the publication of the previous Communication, the two European initiatives already 
referred  to, Euro-NM and EASDAQ, have continued to make progress, as have plans for 
national SME equity markets. 

These  markets  are  for  SMEs  which  need  capital  in  order  to  grow,  either  in  greater 
amounts  or  at  a lower  cost  than  banks will  provide,  because  of the  risk  associated  with 
smaller  growing  companies.  Where  successful,  these  SMEs,  often  based  on  new 
technologies,  can  attain  very  high growth  rates  - well  over  10% per year  -  and  some of 
them  may well become the champions of tomorrow,  although  others will  fail.  It is thus in 
the nature of things that  many SMEs listed on such  markets will become large companies 
at  some  point,  while  not  necessarily  giving  up  their  listing.  An  SME  stock  exchange  is 
therefore  not necessarily one which only lists SMEs; it is one which, compared  with  other 
exchanges, normally concentrates its Initial Public Offerings  on firms at an earlier stage of 
their development. 

The French Nouveau  Marché began trading  on March 20  1996,  and  by the  end  of  1996 
eighteen  companies  were  listed  (including  two  non-French  ones),  with  a  total  market 
capitalisation  of  over  220  million  ecu.  The  Nouveau  Marché  intends  to  become  an 
Europe-wide equities market, and to this end has linked up with other  recently-established 
nationally-based  SME  stock  markets,  the  Nouveau  Marché  of the  Brussels  Bourse,  and 
the Neuer Markt of Deutsche Bôrse AG., together with the Amsterdam  Stock Exchange's 
Nieuwe Markt, to form  a network of markets called  "Euro-NM".  Euro-NM  is a European 
Economic  Interest  Group,  which  aims  to  promote  synergies  by  harmonising  rules  and 
regulations,  integrating  commercial  and  technical  activity,  and  carrying  out  common 
marketing. 

The EASDAQ market  is a private initiative, independent  of any existing stock  exchanges: 
over  ninety  financial  institutions  from  twelve  countries  (including  most  Member  States) 
are  participating  in  the  project  as  shareholders.  The  market  opened  on  September  30 
1996;  the first Initial Public Offering  took place on November 27  1996, and several more 
have  been  made  since.  EASDAQ's  target  is  20-30  such  flotations  in  its  first  year  of 
operations, and a total of several hundred companies listed after five years. 

However,  it is not  only at the European level that  plans are being made for  SME  capital 
markets.  Within  the  Member  States,  a number  of  nationally-based  markets  are  either  in 
operation  or  in  the  planning  stage.  The  "Neuer  Markt"  of  Deutsche  Bôrse  A.G.,  the 

Belgian  Nouveau  Marché,  and  the  Amsterdam  Stock  Exchange's  Nieuwe Markt,  which 
are  all participating  in the  Euro-NM  network,  have  already been  mentioned.  In  the  UK, 
the London  Stock  Exchange's  Alternative  Investment  Market  has been  operational  since 
mid-1995 and has over  160 companies quoted,  with  a market  capitalisation  of over ECU 
3.5 billion. The Vienna stock  exchange recently announced  a special  programme,  entitled 
FIT,  to  allow  SMEs easier  access to  a listing; FIT  is due to  start  in  mid-1997.  In  Italy, 
there are plans to create a new market called METIM (Mercato Telematico delle Imprese 
Medié);  it  will  have  a  national  and  local  orientation,  and  will  be  focused  on  family 
companies as much as technological  ones. In Ireland  too  there  are plans for  a new  SME 
stock exchange. 

The  Commission  strongly  welcomes  all  of  these  initiatives.  As  only  a  relatively  small 
proportion  of  SMEs  considering  a  stock  exchange  flotation  will  be  sufficiently 
international to warrant  a listing on a Europe-wide  exchange, these national  SME  capital 
markets  will  play  an  essential  role  in  providing  SMEs  with  improved  access  to  equity 
finance.  SMEs  which  have  reached  a  stage  in  their  development  where  a  stock  market 
listing is appropriate  need to have a choice of stock  markets -  national  or international  -
according  to  their  specific  needs.  The  new  competitive  climate  in  European  investment 
services  will  oblige  markets  to  focus  more  closely  on  services  to  their  clients,  and  one 
welcome  consequence  of  this  is  the  development  of  capital  markets  providing  a  better 
range of services to SMEs than was hitherto the case. 

The perspectives for  these various markets depend  on a number  of factors,  including  the 
extent  to  which  the  potential  obstacles  described  later  in  this  Communication  are 
overcome.  The  development  of  a  greater  "equity  culture"  in  Europe  will  also  be 
important,  in particular  where  high-risk  high-potential-return  investments,  such  as  SME 
equities,  are concerned.  Evidence from the United  States  shows that  equities  of growing 
SMEs  outperform  the  national  stock  market  indices,  and  in Europe,  equities  in  general 
have consistently produced  better  returns than bonds. Yet  despite the evidence European 
investors, unlike US investors, tend to favour  bonds over  equities,  and  blue-chip  equities 
over  SME equities,  in order  to  reduce the  perceived  risk.  Some welcome  exceptions  do 
exist  however:  in Sweden  35% of private financial  assets is invested  in shares,  compared 
with  17.5% in  the  UK,  10% in  France  and  5.5%  in  Germany;  in the  USA  the  figure  is 
21%5. 

The  new  SME  capital  markets  also  have  the  opportunity  to  learn  the  lessons  from  the 
second-tier  capital  markets  of the late  1980s.  One of the most  important  of these  is that 
sufficient  liquidity  is  an  essential  prerequisite  for  success.  Low  trading  volumes  can 
produce high volatility in share prices, and deter investors from  fear  of being caught in the 
"mouse  trap"  of  being  unable  to  sell  their  shares  because  of  low  demand.  Ensuring 
sufficient  liquidity  will  therefore  be  one  of  the  main  challenges  faced  by  the  new  SME 
capital markets; this can only be achieved with a high level of regulation and transparency. 

The  advanced  information  technology  used  will  also  be  a  key  factor  for  success:  a 
combined information,  trading, clearance and settlement system providing a quick  efficient 
and  "seamless"  service  is  much  valued  by  investors,  and  the  new  SME  capital  markets 
have all put  a great  deal  of effort  into their  computer  systems.  Choice  of trading  system 

Source: German Federal Ministry for the Economy. 

(quote-driven, order-driven or auction, for example) is also important, as different  systems 
are more suitable depending on the size and urgency of a transaction. 

Nevertheless,  the  experience  of NASDAQ  in the  United  States  shows  that  it  can  take a 
number  of  years  for  a  new  market  to  become  highly  successful.  The  new  SME  capital 
markets, European  or  national,  are private  for-profit  ventures,  and  much will  depend  on 
their  commercial  decisions  and  skills,  and  their  cost.  For  in  the  single  market  for 
investment  services,  stock  exchanges  must  compete  with  each  other  on the basis  of the 
service  offered  to  the  customers,  firms  and  investors.  Investor  protection  and  full 
disclosure  of  information  will  also  be  important  in  establishing  confidence  in  the  new 
markets. Nonetheless, it is believed that these markets have a good  chance of success, as 
they fill a  gap  that  was  previously  unsatisfied  in  the  provision  of finance to  SMEs  and 
opportunities to investors. 

III. 

POTENTIAL OBSTACLES TO THE LISTING OF SMEs ON STOCK 
EXCHANGES 

Despite  the  great  potential  for  growth  of the  new European  SME  capital  markets,  with 
the likely beneficial  effect  on the financing prospects of European  SMEs,  some problems 
do remain, which could  slow down progress or reduce its effect.  Many of these potential 
difficulties  lie in the attitudes of SMEs towards their financing,  their expertise in  financial 
management, and the burdens which a stock exchange listing would place on them. 

These problems can be broken down essentially into five questions: 
i)  Does  a  sufficient  number  of  SMEs  exist  in Europe  which  are  suitable  and  ripe  for  a 

stock market flotation,  and if so, how can they be identified? 

ii)  Are  owners  of  SMEs  which  are  ready  for  a  flotation  willing  to  accept  the  possible 

diminution of control which a public share issue is often taken to imply? 

iii)  Do  SMEs  have  the  willingness  and  the  financial  skills  necessary  to  meet  the  high 
financial  information  and transparency requirements of a stock market quotation? 
iv)  Do  SMEs  have  access  to  the  necessary  specialist  advice  and  support  necessary  to 

prepare an Initial Public Offering  of shares (an IPO)? 

v)  Are  SMEs willing and  able to bear the high cost  of the process  of  a stock  exchange 

listing, in terms both of an IPO and of the ongoing costs of a listing? 

To  the  first  question,  the  answer  is  almost  certainly  yes.  It  is  not  only  young  high-
technology companies which might be quoted on small cap stock market for the first time, 
but also more mature family  companies facing  a succession  issue, for  example. Well over 
500,000  companies  exist  in Europe  with  over  20  employees  and  an  average turnover  of 
over  5 million  ecu6,  and  even  if only  a few  percent  of this  total  are  suitable  for  a  stock 
market  listing,  this  would  give  a  figure  of  10-20,000  companies;  this  fits  EASDAQ's 
assessment  of  15,000  companies  in  Europe  potentially  suitable  for  listing7.  These 
companies,  although  only  a  small  minority  of  all  SMEs,  have  the  greatest  job-creation 
potential. Another indicator of the existence of suitable companies for  a public share issue 

6  Source: Enterprises in Europe, Fourth Report,  1996. Figures for European Economic Area. 
7 EASDAQ quoted in the Frankfurter Allgemeine Zeitung, 24.9.1996. 

is the numbers of European companies choosing to be quoted on NASDAQ. About eighty 
European companies are now listed there. 

One possible problem  consists  in identifying  those  companies  which  are  and  those  which 
are not  suitable for  a listing. Many companies may incorrectly believe that  they could  not 
have access to the financing they need by means of a public offer  of shares; evaluating the 
potential of a company for  "going public" is a skill that  directors  of  SMEs do not  always 
possess, and they may be deterred from specialist  external evaluators because of the cost. 
Here  there  could  be lessons  to  be  learnt from practice  in the  USA,  where  there  is  over 
twenty years of experience in evaluating firms for quotation on NASDAQ. 

It is suggested that one possible solution to this problem could be the preparation of some 
form of European auto-assessment  methodology, to help SMEs evaluate their aptitude for 
a  stock  market  quotation.  This  might  involve  the  study  of  experience  in  the  USA  and 
elsewhere, the drawing-up of a guide, available in different  language versions and  adapted 
to the conditions of the different  Member States, to help SMEs evaluate themselves.  Such 
an activity would need to be carried out by an appropriate expert body. 

Another  possible  limiting  factor  on  the  number  of  potential  SME  flotations  on  stock 
markets  is unwillingness  among company  owners to  dilute  or  lose their  control  over  the 
company to the benefit  of new shareholders.  This is an understandable  attitude; however, 
if the alternative is to  rely on expensive bank loans, forgo  expansion  of the company,  or 
make a trade sale, a public share offering  may be the best option (if the company is ready 
for  it).  Moreover,  a  stock  market  listing  does  not  necessarily  imply  the  sale  of  a 
controlling majority  of shares in a company; also, entrepreneurs  may not be aware of the 
range of types of shares that exists, some even without voting rights. 

Financial  institutions  will  naturally  try  to  persuade  companies  identified  as  potential 
market flotations,  and this should make more companies aware of the possibilities open to 
them.  These  activities,  coupled  with  expert  independent  advice,  should  help  overcome 
unwillingness  by owner-run  companies  to  make  a  public  share  offering.  But  if this  does 
not turn out to be the case, there could be a justification  for  public support  in this area, in 
the form of campaigns to bring home suitable SMEs the benefits of flotation. 

It  may  also  happen  that  a  company  does  not  want  to  be  quoted  on  a  public  stock 
exchange  because  of  the  stringent  transparency  rules,  mainly  in  the  field  of  financial 
information.  Or,  it may be willing to  release such  information  but  not  have the  resources 
to  produce the necessary  accounts.  Here,  cultural  and  legal factors  have an influence,  as 
the  amount  of  financial  information  required  from  private  and  public  companies  varies 
considerably  between  Member  States,  but  in  almost  all  cases,  a  stock  market  quotation 
considerably increases the requirements. An additional  cost factor  is that  flotation  on one 
of  the  new  European  SME  stock  markets  may  involve  a  company  needing  to  produce 
accounts  according  to  rules  different  from  those  usually  used  in its  home Member  State 
(for  example International  Accounting  Standards), thus making additional  documentation 
necessary8. 

8  See section lV.iii.2. 

The promotion  of a culture of financial  transparency  across Europe,  including for  private 
companies, could help the situation in reducing the gap in financial  reporting requirements 
between  publicly-quoted  companies  and  others.  Beyond  this,  financial  training  will 
certainly be needed for  companies preparing a prospectus for  a share offer.  It is becoming 
widely  accepted  that  reducing  the  financial  information  requirements  imposed  on  SMEs 
wishing to  issue  shares publicly  could  be counter-productive,  as it would  make  potential 
investors less likely to invest in those companies. 

Even if all these factors  have been overcome, bringing a company to market  is a long and 
complicated  task  which  requires  the  involvement  of  an  expert  financial  intermediary, 
usually  a  investment  bank.  These  financial  skills  may  not  exist  to  the  necessary  extent 
everywhere  in the  EU  to  satisfy  the  potential  demand  from  SMEs,  especially  if the  new 
SME  markets  fulfil  their  full  potential  and  there  are  many  companies  wishing  to  be 
quoted.  Although  providing  such  financial  services  should  clearly  be  left  to  free 
competition  between  financial  intermediaries  in  the  long  term,  if  their  relative  shortage 
looks like hindering the progress  of  SMEs wishing to  float,  it  may become  necessary  to 
stimulate  the  development  of  such  skills by  selective  training  and  information,  especially 
between  Member  States  with  more  highly-developed  capital  markets,  especially  SME 
markets, and other Member States. 

However, expert support  services tend to be costly: bringing a company to a stock market 
flotation  is an  expensive  business.  The  French  Nouveau  Marché  estimates  that  the  legal 
and  accountants' fees  linked  to  the  listing  process  can  represent  up to  13% of the  funds 
raised,  and  the  fees  of  the  compulsory  adviser/market-maker  can  come  to  7%  of  the 
capital  raised9.  Increased  competition  between  financial  intermediaries  such  as investment 
banks will  hopefully  reduce  these costs  in the future,  but  currently,  public  intervention  is 
sometimes  made  within  the  Member  States  to  help  SMEs  meet  them:  for  example,  the 
French Agence Nationale pour  la  Valorisation  de  la Recherche provides,  under  certain 
circumstances,  reimbursable  advances  to  companies  to  cover  part  of the  cost  of  a  stock 
market  Initial Public Offering  (IPO). In many cases the cost  of an IPO can be  transferred 
to the new shareholders, thus reducing the overall cost, but there are still also the ongoing 
costs  of  a  stock  market  listing  (subscription  charges,  legal  and  accountancy  fees,  audit 
fees and so on). 

IV. 

POTENTIAL BARRIERS TO THE CROSS-BORDER TRADING OF 
SHARES ON EUROPEAN SME CAPITAL MARKETS 

In  a  number  of  areas,  potential  obstacles  exist  which  could  hamper  the  cross-border 
trading  of  shares  on  European  capital  markets.  Some  of them  could  deter  individual  or 
institutional investors from  investing in markets in countries other than their own; some of 
them  are  problems  faced  directly  by the  markets  themselves  or  by  intermediaries.  These 
barriers  apply,  of  course,  to  all  European  capital  markets;  however,  they  could  prove 
particularly  acute  for  European-level  SME  capital  markets,  for  which  cross-border 
transactions  might  constitute  a  very  high  proportion  of  their  turnover.  Although  many 

9  Source: Courier ANVAR, June 1996 

potential  barriers  may  become  apparent  in  the  future10,  only  those  which  have  already 
been identified  as potentially important are discussed below. 

IV.i.  Currency-related  problems 

Currency risk is often  cited by securities dealers as one of the most  important  barriers  to 
their  participating  in cross-border  transactions.  Although  the risk  can be hedged  through 
derivative  products,  this  adds  to  the  cost  of  the  transaction.  Also,  for  institutional 
investors  exchange  rate  changes  can  distort  fund  performance  information  and  act  as  a 
deterrent to investment. Besides, the currency-matching requirements imposed by national 
governments  on  institutional  investors  are  only  possible  because  of  the  existence  of 
different  currencies.  Currency  differences  make  the  development  of  interpénétration 
between national markets more difficult  and thus reduce the liquidity of markets. 

The  introduction  of  a  single  currency  is  therefore  an  essential  prerequisite  for  a  truly 
integrated  European  securities  market  in  general,  and  for  the  new  European  capital 
markets for  growing  SMEs  in particular  to  fulfil  their  full  potential.  The  single  currency 
will  increase  the  transparency  of  capital  markets  and  the  comparability  of  investor 
information,  reduce investor risk, and make cross-border transactions easier,  quicker,  and 
cheaper. It will improve the liquidity of European capital markets and, through its strength 
and  stability,  attract  inward  investment  in  European  equities.  Indeed,  European  capital 
markets are one of the areas of the European economy that have the most to gain from the 
rapid introduction of the euro. 

IV.ii.  The regulation of securities trading at the EU level 

It was primarily the advent  of the single market  in the securities field on  1 January  1996, 
with  the  entry  into  force  of  the  Investment  Services  Directive  (ISD)11  and  the  Capital 
Adequacy  Directive (CAD)12, which made possible the creation  of new European  capital 
markets  for  growing  internationally-oriented  SMEs.  Thus,  in  many  ways  the  successful 
future  operation  of  these  new  markets  is  dependent  on  the  complete  and  accurate 
transposition  and  application  by  the  Member  States  of  the  single  market  legislation  on 
securities  trading,  in  order  to  establish  genuine  and  fair  competition  between  securities 
markets.  The  Commission  will play an  active role  in monitoring  the  application  of these 
directives, and in helping to resolve any interpretative questions that may arise. 

Questions  concerning  the  practical  application  of  the  Directives  will  require  close  co 
operation between the regulatory bodies of Member  States; a hypothetical example would 
be  if  an  investment  firm  authorised  in  one  Member  State  were  to  commit  serious 
misconduct  in a another Member  State. Co-operation  between  national regulatory  bodies 
in the securities field is already strong, being legally underpinned  by specific  requirements 
in  Directives  such  as  that  covering  stock  exchange  listing  particulars.  In  1995  the 
Commission  adopted  a  proposal  for  a  Directive  on  the  setting  up  of  a  Securities 
Committee13,  which  would  replace  the  existing  High  Level  Securities  Supervisors 

10 See "Legal and tax issues arising from  cross-border dealings on EASDAQ", European  Venture 

Capital Association and European Association of Securities Dealers,  1996. 

11 93/22/EEC, of 10.5.1993. 
1293/6/EEC, of 15.3.1993. 
13 COM (95) 360, 17.07.95. 

Committee,  and have competence in respect  of both the Investment  Services and  Capital 
Adequacy Directives, but this still awaits  approval by the Council in co-decision with the 
European  Parliament. 

The  Directive  setting  up  a  Securities  Committee  will, when  adopted,  bring  into  being a 
Committee  which  will  assist  the  Commission  in  the  exercise  of  technical  rule-making 
powers  under  the  ISD  and  the  CAD.  The  Securities  Committee  will  also  be  a  useful 
advisory  body  which the  Commission  can  consult  when  envisaging  new  initiatives  in the 
field  of  securities  markets.  It  will  not  have  any  role  in  the  day-to-day  regulation  of 
securities,  which  remains  the  responsibility  of  national  regulators.  Co-operation  between 
regulators is requested  under securities market directives, and this is given practical  effect 
by  the  drawing-up  of  bilateral  agreements  between  regulators,  called  "memoranda  of 
understanding". 

Investing in SMEs involves high risks, and  potentially  high returns.  It  can reduce  overall 
risk,  if  carried  out  as  part  of  a  strategy  of  diversification  of  investments  and  if  the 
investments  made  are  sufficiently  spread.  The  objective  of  regulation  of  SME  capital 
markets,  as  of  other  capital  markets,  is  to  establish  transparency  and  thus  to  protect 
investors,  not  from  investment  risks,  but  from  any  abuse  by firms, market  participants, 
other investors or the markets themselves. 

In the longer term,  more wide-reaching  regulatory  issues look  certain to  arise.  Given the 
current  trend  of market  developments,  with  internationalisation  of trading  and the use of 
novel  trading  systems  other  than  traditional  stock  exchanges  (including  so-called 
Proprietary Trading Systems and possibly the Internet), it appears possible that  regulatory 
authorities  may  face  an  increasingly  difficult  task  in.enforcing  existing  legislation.  Also, 
with the spread of cross-border electronic trading it could become increasingly difficult  to 
decide  when  and  where  trades  are  actually  performed,  and  the  question  of  which 
regulatory body is competent  could become harder to  determine.  These issues, if they do 
arise, will need to be monitored  and  evaluated  for  their  implications  on  securities  market 
regulation. 

IV.iii.  Differences  in national laws and practices 

In the  newly-established  single  market  for  securities,  and  especially  on  European  capital 
markets for  growing  SMEs, more and  more transactions  will involve two, three or  more 
Member  States. Differences  in national  laws  and  practices  could  act  as a disincentive  to 
such transactions. 

National  legislation  in the three  areas discussed  below may have  an important  incidence, 
direct or indirect, on cross-border trading in shares on SME capital markets. 

IV. Hi. 1. 

Taxation. 

The  first  of  these  is  the  tax  area,  where  foreign  investors  can  find  themselves  at  a 
disadvantage compared with investors based in a Member State. For example, both capital 
gains  tax  and  withholding  tax  on  dividends  varies  enormously  between  Member  States. 
Double assessment  for  tax between EU countries will usually be avoided through  double 
taxation  treaties,  though  this  can  necessitate  additional  administrative  procedures.  Net 

income can depend  on whether the country  of origin of the shareholder  operates  a credit 
or  an  exemption  system  with  regard  to  dividends  originating  outside  the  country. 
However,  as  investors  in  high-risk,  high-return  SME  markets  will  probably  be  seeking 
capital  gains  rather  than  dividend  revenue,  it  is  hard  to  know  to  what  extent  these 
differences  will influence their investment decisions. 

In  certain  Member  States,  specific  tax  reliefs  exist  to  encourage  investment  in  equities. 
For  example,  schemes  whereby  losses  made  on  investments  in  unquoted  private 
companies (up to a ceiling) can be set against overall tax liabilities exist in several Member 
States, and in France and the United Kingdom the relief is maintained even if the company 
subsequently  lists on the Nouveau  Marché  or  AIM  respectively.  In  all  such  cases  where 
specific  national tax  reliefs  exist,  it would be desirable for  them to be  extended  to  cover 
investments made on other European capital markets (at least for  companies  incorporated 
in  the  Member  State  concerned);  this  would  avoid  possible  tax  discrimination  between 
different firms from the same Member State, according to which stock market they choose 
to list on. 

In  April  1996  the  Commission  produced  a  discussion  paper  for  the  ECOFIN  Council, 
"Taxation in the European Union"14, which noted that as regulatory and economic barriers 
to  the  establishment  of the  Single Market  are  progressively  removed,  taxation  is  rightly 
perceived as an increasingly important  residual factor  preventing the full  realisation  of the 
Single  Market  and  its goals  of  sustainable  growth  and  a high  level  of  employment.  Tax 
disadvantages  linked  to  cross-border  financial  transactions  were  identified  as  a  factor 
complicating  the  lives of citizens.  The  Council  decided  as a result  to  set  up  a  high-level 
group  to  examine  ways  of  making  progress  on  these  and  other  tax  issues  affecting  the 
single market.  The  Commission's  report  on the  work  of this group  was  published  on  22 
October  199615.  It concluded that  action is necessary to eliminate the existing barriers  to 
cross-border income and capital flows;  subsequently, the Dublin European  Council of 13-
14  December  1996  endorsed  the  setting-up  of  a  permanent  group  to  take  a  strategic 
overview  of  tax  policy,  and  to  co-ordinate  national  tax  policies,  while  respecting  the 
principle of subsidiarity. 

IV. Hi. 2. 

A ccounting standards. 

This  is  another  area  in  which  national  differences  could  discourage  investors,  although 
research16  suggests  that  large  investors  are  used  to  dealing  with  accounting  differences 
and  that  other  factors  have  greater  influence  over  their  decisions.  The  International 
Accounting  Standards  Committee  is  currently  attempting  to  produce  a  core  package  of 
accounting  standards  for  adoption  by  IOSCO  (the  international  securities  regulators' 
body)  in  1998; in its Communication  of  November  1995  "Accounting  Standards,  a new 
strategy vis-à-vis International Harmonisation"17, the Commission declared its intention  to 
become  involved  in  this  work.  The first priority  of  its  strategy  is  to  enable  large  listed 
companies  to  produce  only  one  set  of  consolidated  accounts  that  can  fulfil 
the 
requirements  of  the  EU  Accounting  Directives  and  those  of  International  Accounting 
Standards  (IAS).  A  task  force  set  up  in  November  1995  has  concluded  that  with  the 

14  SEC(96) 487 final, 20.03.1996. 
15  COM(96) 546 final. 
16  The European Equity Markets, European Capital Markets Institute,  1996 
17 COM (95) 508 final 

exception  of  two  minor  matters,  European  companies  can  prepare  their  consolidated 
accounts on the basis of existing IAS without  conflicting  with the Accounting Directives. 
Its report will constitute the basis on which each Member State will decide whether and to 
what  extent  companies  can  apply  IAS when  they wish to  do  so.  In the  meantime  capital 
markets wishing to attract  business, and firms wishing to  attract  investment,  must  decide 
which  accounting  conventions  and  practices  to  adopt,  within  the  limits  imposed  by 
national rules. 

IV. Hi. 3. 

Corporate governance 

Corporate  governance,  in  its  widest  sense,  involves  the  rights  and  duties  of  the 
management  of  a  company  towards  its  shareholders  and  other  stakeholders,  and  the 
mechanisms  which  the  latter  have  for  controlling  the  activities  of  the  management.  The 
composition  and  powers  of the  board  of  directors  and  the  information  which  they  must 
provide  are  important  aspects  of  corporate  governance.  Protection  of  minority 
shareholders is another,  and it is mainly in this area that  corporate governance  issues are 
relevant  to  the  new  SME  capital  markets,  as  it  is  possible  that  absence  of  shareholder 
protection  could  discourage investors from  investing in firms listed  on such markets.  The 
directors  of  companies  being  floated  on  these  new  markets  may  be  inexperienced  in 
shareholder  relations,  and  national  differences  in  such  matters  as  conceptions  of  the 
directors'  duties  and  the  structure  of  the  board  of  directors  (single-tier  and  two-tier 
boards, for example) will further  complicate matters for investors. 

In Europe,  shareholder interest in governance is increasing,  and  institutional  investors  are 
also  taking  greater  interest  in  the  internal  management  of  the  companies  in  which  they 
invest.  Institutional  investors  based  outside  the  EU,  especially  in the  United  States,  are 
also  sensitive  to  corporate  governance  issues.  The  Commission  welcomes  the  renewed 
emphasis in several Member  States on good  standards of governance,  and believes that a 
Europe-wide debate on appropriate corporate governance standards would be helpful. 

In  addition  to  national  and  European  legislation  on  corporate  governance,  stock 
exchanges  may  decide  to  impose  supplementary  corporate  governance  requirements  on 
companies  wishing  to  be  quoted  on  them,  and  such  standards  can  play  a  part  in 
competition between  exchanges. Beyond this, it remains to be seen whether a clear  set of 
European  corporate governance principles would be useful,  and if so, what form  it might 
take and what content it would have. In its recent Green Paper on statutory auditing in the 
EU18, the Commission  pointed  out that  it might be useful  to  issue a Recommendation  at 
EU level on possible ways to improve the present system of corporate governance. 

IV. iv.  Institutional  investment 

Institutional  investors,  including  collective  investment  funds,  insurance  companies  and 
pension  funds,  will  be  a  key  in  determining  the  success  of  the  new  European  capital 
markets for  SMEs (although individual investors will certainly play an important role too). 
On  US  stock  markets  institutional  investors  own  31%  of  shares,  with  pension  funds 

18 COM(96) 338 final, 24.07.1996.. 

10 

owning 24%; in the UK the figures  are 59% and  51%  respectively,  in Germany 22% and 
12%, and in Italy  11% and 1%19. 

Pension funds  in particular  are set to undergo much growth in coming years: the pressure 
on  unfunded  social  security  pension  schemes  in  many  countries  due  to  an  ageing 
population  and  unemployment,  are  likely  to  lead  to  a  great  expansion  of  provision  for 
retirement  through  funded  pension  schemes.  One  report20  estimates  that  pension  fund 
assets might increase by up to nine times, to over  10,000 billion ecu, by 2020. These  funds 
will  be  looking  for  new  investment  opportunities,  which  will  inevitably  lead  to  the  new 
SME growth  markets being closely analysed  by pension  funds,  and  by other  institutional 
investors, for such opportunities. 

However,  the freedom  of such  funds  to  invest  freely  is currently  limited  by a number  of 
restrictions  in  Member  States.  Many  of  these  restrictions  are  normal  and  justifiable 
prudential  requirements  (and  in  addition,  many  funds  have  their  own  internal  risk-
diversification  rules,  such as restrictions on investments in unlisted  securities, which  fund 
managers  must  respect).  But  many  nationally-imposed  restrictions,  such  as  certain 
prohibitions  on  foreign  investments,  or  obligations  to  invest  in  government  bonds,  are 
discriminatory.  Some requirements to invest in matching currencies may be excessive and 
not  necessarily  prudential.  Such  restrictions  can  lead  to  investors  obtaining  sub-optimal 
returns on their investments, and can also lead to distortions: for  example, a pension  fund 
may find itself unable to invest in a company from the same Member State simply because 
it is quoted on a foreign  market. 

As  European  capital  markets  for  growing  SMEs  are  by  their  nature  international,  and 
because  they  will  need  substantial  institutional  investment  in  order  to  succeed,  these 
national  restrictions  on investment  could  have  a disproportionately  higher  effect  on them 
than  on  other  capital  markets.  The abolition  of these  restrictions  is essential,  not  only in 
the  interest  of  pension  fund  contributors  and  of  companies  seeking  equity  funding,  but 
also for  the  completion of the  single market  and the  application  of the  Treaty  provisions 
on  the  free  movement  of  capital.  The  Commission  has  now  written  to  certain  Member 
States asking that they take  steps to remove discriminatory  restrictions  not  authorised  by 
the  Treaty  of Rome21.  Failure  to  act  could  result  in infringement  procedures  before  the 
Court of Justice.  In addition,  efficient  capital markets will be one of the  subjects  covered 
in a Green Paper on  pension funds, currently being prepared by the Commission. 

V. 

CONCLUSIONS 

As  a  consequence  of  the  difficulties  faced  by  European  SMEs  in  accessing  capital 
markets, they are largely undercapitalised:  only  10% of European  SMEs surveyed in 1996 
were  financed  by  external  equity,  while  49%  had  long-term  loans,  and  54%  had 
overdrafts22.  Firms take many more years on average in Europe to be floated  on  a stock 

19 Source: Corporate Governance in Europe, Centre for European Policy Studies,  1995 
20  Source: European Pension Funds: their impact on European capital markets and competitiveness, 

European Federation for Retirement Provision, June  1996 

21  Article 73 forbids restrictions on capital movements, except proportionate ones base on prudential 

grounds. 

22  Source: Grant Thornton Business Survey  1996 

11 

exchange  than  in  the  United  States.  The  initiatives  for  European  SME  capital  markets 
over  the  last  few  years,  are therefore  opportune  and  necessary,  although  they  constitute 
only  part  of  the  solution.  A  start  has  been  made  towards  a  structure  of  SME-oriented 
capital markets, European and national, which can fill this important gap in SME  financing 
and  provide  attractive  investment  opportunities.  New  technologies,  and  a  high  level  of 
transparency,  should  enable  these  markets  to  attract  new  investment,  but  the  rapid 
technological advances also raise issues concerning how best to regulate capital markets. 

The  establishment  of  these  new  markets  has  been  made  possible  by  EU  single  market 
legislation  in  the field of  securities  trading,  essentially  the  Investment  Services  Directive 
(ISD), which removed former insuperable obstacles to the establishment  of fully  European 
markets,  such  as  the  existence  of  national  monopoly  markets  with  restricted  access  for 
foreign dealers. Nevertheless, a number of potential difficulties  remain, which could hinder 
the access of SMEs to equity capital, and the development of markets designed to respond 
to their needs. Many are questions for individual stock exchanges to decide as part of their 
strategy.  Those  dealt  with  here  -  problems  of  access  for  SMEs  to  stock  exchanges  in 
general,  and  potential  obstacles  to  cross-border  trading  in  shares  on  European  capital 
markets for growing  SMEs - may require intervention,  either at the level of the European 
Union or that of Member States, and this Communication suggests some lines of action. 

Improving access for  SMEs to equity capital via listing on a stock exchange, and tackling 
the  possible  hindrances  to  this  within  SMEs  themselves,  is  one  of the  objectives  of  the 
Commission's  Third  Multiannual  Programme  for  SMEs,  adopted  by  the  Council  on  9 
December  199623.  The  Multiannual  Programme  also  includes  the  exploration  of 
innovative financial instruments for  SMEs, and in this context  the Commission  intends to 
study  the  feasibility  of  other  means  of  SME financing through  securities,  including  for 
example the issuing of bonds. 

The improvement  of access for  SMEs to equity finance,  both through the development  of 
suitable  SME-oriented  capital markets, and through helping  SMEs overcome the inherent 
difficulties  which  can  prevent  them  being  floated  on  such  markets,  will  have  a  strongly 
beneficial  effect  on  the  European  economy,  and  on  the  level  of  employment.  Increased 
access to equity finance would produce a chain reaction of positive effects  for  companies: 
it would allow them to invest in research  and expansion; by decreasing  debt-equity ratios, 
it  would  make  banks  more  willing  to  supply  further  debt  finance;  by  improving  the 
opportunities  for  venture  capitalists  to  exit  their  investments  it  would  free  up  venture 
capital  for  investment  in  start-ups  and  young  companies.  There  would  also  be  wider 
economic benefits:  better  opportunities  for  European  investors,  especially  pension  funds, 
thus alleviating current difficulties  in funding  pensions; more inward investment to Europe 
from  elsewhere; the development of financial  services in Europe. 

For  all  these  reasons  the  Commission  believes  that  the  opportunities  provided  by  the 
creation  of  national  and  European  capital  markets  for  growing  SMEs  should  be 
maximised.  All efforts  should be made, including the measures described  or  suggested in 
this  Communication,  to  further  the  establishment  of  a  genuine  SME  equity  culture  in 
Europe. 

23  97/15/EC. Official  Journal L 6/25 of 10.1.1997. 

12 

ISSN 0254-1475 

COM(97) 187  final 

DOCUMENTS 

EN 

08  09 

Catalogue  number  :  CB-CO-97-179-EN-C 

ISBN  92-78-19069-1 

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